Treasury to replace Bank of Israel makams with T-bills

Central bank to expand its use of repurchase agreements to influence interest rates

Bank of Israel governor Stanley Fischer continues to move the central bank closer to international financial procedures and standards. He has initiated a move, with the agreement of the Finance Ministry, to have the bank stop issuing short-term bonds (makams), which are one of the central bank's most important tools for controlling short-term interest rates.

Instead the treasury will issue short-term bonds similar to United States treasury bills, while the central bank will expand its use of repurchase agreements (repos) to manipulate interest rates - a common method used by most of the world's central banks.

Fischer's vast economic and financial expertise has led him to attempt to bring the bank closer into line with standard international practice. In this case Fischer will now separate the treasury's role of raising money for the government from the bank's function of regulating interest rates only through its actions in interest rate markets.

The separation of selling bonds from controlling interest rates should have no effect on interest rates themselves, or the bank's rate policies. The change is only a technical one, meant to replace a method used by the bank for controlling rates for another, more widely accepted one.

The treasury will now raise funds over a wide range of time periods, and may possibly even issue short-term bonds for a few months only - similar to U.S. T-bills. Fischer hopes that such a change will move Israeli financial markets closer to internationally accepted practices, which should make it easier for foreign investors to invest in Israel. Foreigners are well acquainted with the repo interest rate markets.

This move should also help Israeli market makers significantly. In addition, the intention is to develop the repo market as a competitor to the banks as an additional way of expanding the Israeli financial sector and markets.

Less than a year to go

The Bank of Israel and the treasury have already agreed in principal on the step, but the technical details have not yet to been worked out. Estimates are that the bank can stop issuing the short-term Makam bonds in less than a year.

Makam bonds are short-term government securities issued in shekels for a one-year period.

This has made the Bank of Israel an exception among central banks, being the only one who raises funds directly through bond issues. The reason that such activity is not acceptable is that the central bank does not need the capital: the treasury does, to finance government spending. In fact, the money raised today through the Makam bonds is actually not used at all; it is only placed in a closed deposit, which is used at the end of the designated period to pay off the bonds. The Bank of Israel has been issuing the bonds for years, since at the time it was the method used to create a market for short-term shekel bonds - which did not exist in Israel until 15 years ago. The bonds also represented an easy way to control interest rates.

However, over the years the short-term bond markets have developed and the bank no longer feels a need to maintain this market anymore. Fischer prefers to participate in the market as just another player, as is accepted in the rest of the world, and to stop actively creating the market.

The interest rate markets involve the exchange of short-term loans and bonds, often for only a single night, between bond who need loans, and between depositors who are looking for higher interest than that offered by the banks.

Two weeks ago the Knesset passed a law regulating repo deals, allowing the Bank of Israel to begin to develop large-scale repo markets.

Repo markets allow players to short-sell bonds. The system, based on borrowing bonds for a pre-stated period of time, will operate through the stock exchange. Stock market members and foreign banks can sell bonds they don't actually own, go into a sort of overdraft on bonds, subject to proper collateral. The repo system is innovative, because it enables the development of a market in derivatives and futures on bonds.